Jul 04, 2014

Estate Planning Basics, Part 1: What to Know About Intra-Family Loans

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AWANE and Thomas Brady & Associates are working together to help AWANE Members face the many issues associated with estate planning, business planning, and insurance review and placement. As such, this is the first in our ongoing Estate Planning Basics series. This series will address many questions and issues to help you protect your life’s work.

To guide this first installment of Estate Planning Basics, we have posed a situation to consider regarding intra-family loans, and then replied in detail with information any interested party should know and will find applicable value in:  


Situation:

My oldest daughter has just gotten married and I would like to help her and her new husband with the purchase of a new home.  She has asked us for some help in buying a house, but I’m not sure I can afford to permanently part with a significant part of my savings.  I am getting close to retirement age and want to make sure I can take care of my wife and me after I retire.  Should I just give them the money, or is there a better way to help them out?

Response:

Making an outright gift to your daughter is certainly one way that you can approach this situation.  It is clean and simple and there are no strings attached.  Of course, given your concerns about retirement, such a significant outright gift might be more than you are willing to do at this time.  It might also not reflect the lessons of financial responsibility that you want to teach your children.

One possible solution for you could be an “intra-family loan”, one of the best kept estate planning secrets.  An intra-family loan is an arrangement where one family member lends money to another family member at an interest rate that is much lower than the prevailing market interest rates.  The intra-family loan is one of the easiest and most effective estate planning tools out there, especially in this low interest rate environment.  It is simple to implement and the annual or monthly management is no more complicated than your average mortgage payment.

In order to qualify the loan as a legitimate loan (and not a gift), the loan must use an interest rate equal to the Applicable Federal Rate (the “AFR”).  The AFR is a set of interest rates that is published monthly based on outstanding marketable obligations of the United States.  There are short-term, mid-term and long-term rates which are determined based on the preceding two months’ average market yield on marketable Treasury bonds with corresponding maturity.  The short-term rate applies to loans that are less than three years in duration.  The mid-term rate applies to loans that are more than three years but less than nine years in duration.  The long-term rate applies to loans that are more than nine years in duration.

The following table illustrates the AFRs for July 2014:

AFR RATE TABLE                            Compounding Period
Annual Semi-annual Quarterly Monthly
Short-term 0.31% 0.31% 0.31% 0.31%
Mid-term 1.82% 1.81% 1.81% 1.80%
Long-term 3.06% 3.04% 3.03% 3.02%

 

Especially for someone in your situation, where you might technically be able to afford to make a significant outright gift to your child but you’re just not so comfortable with it, a loan might be the solution for you.  It accomplishes the primary objective of helping your daughter with the purchase of a home by minimizing the interest rate and it also ensures that the money will ultimately be available to you when (if) you need it.  In addition, it has the potential to be a great estate planning tool as well.

The estate planning benefits are very straightforward.  If you were to lend your daughter $1,000,000 for a period of three years, your daughter would be free to invest those funds in any way that she choose.  Of course, she would have to then return those funds to you at the end of the three years, with interest.  If the money is invested in such a way that it earns more money than your daughter has to repay to you, your daughter can walk away with a nice profit.  For example, if you had lent your daughter $1,000,000 for a single year on January 1, 2013 and the money was invested by your daughter in the S&P 500 Index for all of 2013 your daughter would have earned 29.6% on her investment, or $296,000.  Based on the minimum interest rate of 0.21% that you would have had to charge for a loan in January of 2013 (see below for an explanation), you would have been repaid a total of $1,002,100 at the end of the year, leaving your daughter with a profit of almost $294,000.  From an estate planning perspective, this works beautifully because all of that profit (i.e., the arbitrage above the applicable interest rate) passes to your daughter without any gift or estate tax, as long as the stated interest rate on the loan is greater than or equal to the AFR.

The same example can be made with the purchase of a home.  The big difference, of course, is that the invested funds are not returning any liquid assets to repay the loan.  For that reason, it is important to make sure that your daughter and her husband have the available resources to pay you back on a monthly or annual basis (just like they would with a traditional mortgage).  The debt should be collateralized or secured and you should maintain records and written evidence of demands for payments and actual payments made by your daughter.

Finally, with respect to loans used to finance the purchase a home, be aware that in order for the interest payments to be deductible by your daughter, the debt must be secured by the qualified residence, the residence must be able to be foreclosed upon in the event of default and the security interest must be recorded or otherwise perfected under state law.

Failure to follow some of the basic parameters may result in the imposition of gift or estate taxes or, in the case of the loan to purchase real estate, the loss of the mortgage interest deduction.  Working with a qualified estate planning lawyer is always recommended.

From a practical perspective, you will have income to the extent of any interest payments that are due, but the beauty is that the payments stay within the family (as opposed to a bank) which helps to preserve the overall family wealth.  The current low interest-rate environment means that you can lock in these benefits for the long-term.

© Copyright 2014 Thomas Brady & Associates, Boston, Massachusetts.  All rights reserved.  To ensure compliance with IRS requirements, we inform you that any federal tax advice contained in this communication (including any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (including any attachment).


AWANE is proud to endorse Thomas Brady & Associates. For more information on estate planning and intra-family loans, please visit AWANE's Estate & Business Planning Services page or contact us. We're always here to answer your questions and help you navigate life's most complicated situations!